The mad rush to sell commitments to private equity funds on the secondary market isn’t without consequence. PE firms are keenly aware that no more than 2% of a fund’s LP interests can sell on the secondary market. If they do, the fund is no longer protected by safe harbor laws that guarantee that all-important “private” status and, more importantly, “private” taxes.
If more than 2% trades on the secondary market, it could be audited and deemed a publicly-traded partnership, or PTP. Examples of PTPs include publicly-traded mutual funds. The PE fund is no longer a flow-through vehicle and, as a result, returns end up being taxed twice (GPs get taxed on the income, LPs get taxed on it after distributions). There also are safe harbors for up to 10% if it is sold in large “block transfers;” ultimately this relates to how many LPs there are.
Understandably, some firms are concerned about the number of commitments that their LPs will sell on the secondary market. “The other side of the coin is so draconian,” as one source said. But GPs typically have veto power over secondary sales written into their partnership agreement. So, in order to keep their safe harbor guarantee, a number of firms have told eager-to-sell LPs they’ll just have to wait. Get in line for 2009. One lawyer I talked to said there’s a mega-buyout firm that has a two-year waiting list of eager-to-sell LPs.
But a caveat: The odds of a private equity firm suddenly being reclassified as a publicly traded partnership are not high, as both GPs and LPs are finding ways to circumvent the safe harbor requirements. To date, no firm has been audited, but it’s clearly on the minds of GPs given the LP liquidity issues and activity in secondaries.
One way LPs are getting around this? Synthetic transfers. I’ve heard about this once or twice before, and basically, it can be structured like a joint venture. Say an LP has liquidity issues and needs relief for meeting capital calls, but doesn’t want out of private equity altogether. The LP can enter into a contractual arrangement with a secondary buyer, where both are beneficiaries of the interest, and secondary buyer funds the capital calls in the near term, but no ownership is changed. I’m not sure about every detail of this arrangement, but several lawyers and secondary buyers have mentioned it to me as a way to skirts the whole “wait in line” rule.
Another way anxious sellers can get around it is through private bulletin board systems called “qualified matching systems.” From my understanding, it’s like a private Craigslist of secondary stakes, except prices are not posted. Up to 10% of the interests in a fund can trade on the board, which has a minimum posting time of 15 days and maximum of 45. I’ve heard at least two GPs have established their own captive qualified matching services for their funds, which gives them control over the secondary sale process.